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How Risky is a Kuwaiti Portfolio? A selection of Credit Risk Ratings

Date: February 11, 2014 Author: Ramzi Watfa
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You would expect that a seemingly wealthy country that enjoys a high level of oil production for a relatively low demographic base would produce vibrant and low risk enterprises. If so, then why are almost half of the listed companies we sampled in Kuwait are risk rated above 6.5; ie watch listed or worse? A surprising perspective on the country’s credit risk rating.

Using 6 Sigma’s Credit Risk System (http://www.6sigmagrp.com/index.php/rcms.html), we risk rated 36 of Kuwait’s largest firms, covering sectors as diverse as Real Estate, Industrial, Services and Food. To our amazement, 42% of the companies sampled exhibited risk ratings above 6.5. The rating scale is 1 to 10, with (a) 1 to 4 representing Investment Grade companies (low risk), (b) 5 and 6 representing acceptable but higher risk, and (c) above 6 being either watch-listed or defaulted. Why would a rich country like Kuwait have so many listed companies that seem to have difficulty with Credit Risk? Underline listed…

List of RR Listed companies Kuwait
http://www.6sigmagrp.com/index.php/rcms.html

Mismanagement on both the Obligor and Banker’s side Perhaps the explanation is in the way companies behave in the country. Take a seemingly industrial venture that decides it is very good at predicting stock market trends, borrows from banks, and invests the funds in shares. Not only did management waste its time being concerned with non-core activities, with the subsequent downfall of the stock market, the ability to meet bank obligations became very weak to nonexistent.

It turns out that in addition to a somewhat weak business engine (assessed using 6 Sigma’s signature credit risk analysis methodology), most companies’ high-risk profiles were compounded by the fact that they were financed by a multitude of bankers with total disregard for not only their risk profiles, but also their needs. The banks seem to have endowed them with so much financing that their meager cash flows could hardy sustain interest payments, never mind principal. The abuse of facilities by these companies is also a prevalent trait, with most of it channeled to withdrawals, stock market investments, or other group companies outside of the actual business.

One would think that this is an obvious problem that should have been detected and resolved by the banks from the outset. At the very least, the banks should have watched where the funds were flowing by using simple cash flow analysis. Alas, these same companies are not declared persona non grata and banks continue to finance them irrespective. Interest payments are made from an ever-increasing bank debt, and as long as the balance sheets and income statements are growing, the problem is never detected.

Why don’t banks see the picture and do something about it? So why are banks seemingly indifferent or blind to this fact? We believe it is because of the following reasons:

1. Lack of Cash Flow analytical techniques: The picture is so obvious when using cash flow analysis; but surprisingly banks do not use cash flow analysis in their due diligence despite Basel guidelines to that end.

2. Reliance on Traditional Ratios: Traditional ratios to analyze obligors (Current Ratio, Quick Ratio, Working Capital etc) were invented back in the 1930s and were assumed to reflect the liquidity of an obligor for a given gap between current assets and current liabilities. The argument was that if the obligor were to be liquidated and its current assets were valued at more than current liabilities, short-term bank debt would be repaid in full. The use of these ratios has two major flaws:

a) They are lagging indicators, being ratios of subtotals rather than actual numbers—something akin to judging a book by its cover. b) Under a liquidation scenario, the obligor would be lucky to acquire a fraction of the true value of the current assets held.

3. Using Peer Analysis in Risk Rating Obligors: Many bankers, and indeed several international risk-rating agencies place much focus on Peer Analysis, the analysis of ratios amongst companies of the same industry. We believe the reasons why Peer Analysis found a following is when analysts were a little confused trying to explain whether say a current ratio of 1.52 was a good ratio or not. The only way to analyze such a ratio is to compare it with a benchmark, and hence the industry average. This is the syndrome of the blind leading the blind.

4. Lack of Structuring of Facilities: To make matters worse, bankers seem to lack an ability to calculate obligor needs, and tie these needs to their appetite for business based on obligor risk profiles. Most banks are driven by what the obligor requests, on the assumption that the delivery of service (in this case banking) is based on client demand. Little do they realize that in their attempt to maximize flexibility, obligors tend to request much more than their needs from all their banking connections, thereby allowing for misuse of funds, and the gradual slide into default. The trick in banking is to structure the right facility for the right obligor based on its risk profile. The higher the risk profile, the tighter should be the structuring.

A more elaborative description of the above can be seen in our 5 Common Mistakes in Credit Analysis which can be acquired from https://ki156.infusionsoft.com/app/form/default-campaign-form.

© 2014 6 Sigma Group

While the information contained herein is believed to be accurate, neither 6 Sigma nor any of its affiliates or subsidiaries or its employees makes any representation or warranty, express or implied, as to the accuracy or completeness of the information set out in this document or that it will remain unchanged after the date of issue of this document, and accordingly neither 6 Sigma nor any of their respective affiliates or subsidiaries or employees has any responsibility for such information. This document is not intended by 6 Sigma to provide the sole basis of any credit decision or other evaluation and should not be considered as a recommendation by 6 Sigma that any recipient of this document should purchase an equity stake in, provide credit facilities to, or conduct any business with any company(ies) listed in this document. Each recipient should determine its interest in the information provided herein upon such independent investigations as it deems necessary and appropriate for such purpose without reliance upon 6 Sigma.

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